Why I Believe in Investing in Real Estate for Appreciation

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The two basic principles for investing in real estate are cash flow and equity build-up.  Some investors lean towards creating more cash flow, some favor equity build-up, but most try to find properties that have some blend of the two that they feel comfortable with. While every investor has his or her own philosophy for investing, I personally tend to lean towards investing for appreciation.

I realize some people shutter at the idea of appreciation, so let’s call it a recovery in values. Once houses return to a level where homes can be bought and renovated at or near replacement cost, we can start calling it appreciation. In Atlanta, we are buying and fixing homes for half of replacement cost, so we have a lot of room for price recovery before we even consider appreciation.

With the ability to buy properties at or below 50% of their previous selling price just a few years ago, it would stand to reason that there is an opportunity to capitalize on recovering values.  Yes, there are also tremendous opportunities to create great cash flow from these properties as well, but I personally like the idea of buying an asset that will not only generate income, but will also see a significant increase in value over the coming years.

I realize that many investors hear this and speculate that housing values may not recover for a very long time and therefore only want to invest in houses that create cashflow without regard for appreciation. While they may be right, I tend to think that basic economics will drive prices back up. In fact, if you look at a market such as Phoenix, this is already happening.  Phoenix has been a hot investment market over the last few years as home values dropped dramatically from their peak in the mid 2000’s. However, just in the last year prices have increased over 30% and inventory is way down as demand from investors has consumed much of the foreclosure inventory. In fact, the chief economist for the National Association of Realtors said that “Phoenix will be a benchmark city to monitor.”

Living in Atlanta, I look at what’s happened in Phoenix over the last year and see the same fundamentals at work in my market. Our real estate inventory has declined 3 years in a row and has actually dropped a whopping 36% just since June of last year. In addition to this, demand from investors has been red hot over the last few months with closings already 12% higher this year than they were a year ago at this time. I’m no economist, but I did take Economics 101 and 102 in college and can still remember my supply and demand graphs.  With a shrinking supply of houses and an increase in demand from buyers, Atlanta should experience something very similar to Phoenix in the way of increasing values.

As such, I’m an investor who believes that buying for the potential increase in real estate values makes sense. Yes, I believe that cash flow is important, but I also don’t want to stick my head in the sand and pretend that there isn’t a very real window of opportunity to buy properties with the potential for appreciation (price recovery) right now.  As real estate investors, it is critically important to look around the country and study how other markets have been affected by changing market dynamics. Understanding these principles can help you decide where and how to maximize the profitability of your next investment.

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About Author

Ken Corsini G+ is the founder of Georgia Residential Partners, LLC - a real estate investing firm based in Atlanta, Ga focused on creating turn-key investments for investors all over the country. He's been investing in real estate since 2005 with hundreds of real estate transactions.

16 Comments

  1. Ken,

    I think you hit the nail on the head, why not have the best of both worlds. If your going to buy for cash flow, then purchase in areas poised for appreciation. I certainly don’t rely on appreciation for my business model, but it doesn’t hurt.

    Jason

  2. Steve Toohey on

    Ken, I agree. In addition to cash flow now, I compute expected price recovery over the next 5 years. Using projections like this are obviously uncertain, but as a buy and hold investor with an expected minimum holding time of 5 years, it is not hard to project an annual 4% equity increase. I’m not depending on this increase, but the likely bump in equity and the tax benefits of buy and hold are factors steering me away from flipping properties in this market.

  3. Your article confuses me a bit as you seem to mix terms. At times you are talking replacement cost… other times you’re talking about market prices from a few years back. I’m hoping you aren’t equating the two. Buying at a 30% discount from a 2008 price doesn’t mean you bought at a 30% discount to replacement value. I’d challenge there’s little to no direct correlation between peak pricing around the country and the current replacement cost. I’m very curious as to how you are estimating your replacement costs to decide if there’s equity to be had? Land is cheaper now days, labor is definitely cheaper, material costs may be higher… what metrics are you using?

    Beyond that, being that the market tanked across the country, aren’t most homes below replacement cost? Won’t all homes eventually go back to that price point? If all homes are going to appreciate, why wouldn’t you invest for cash flow? Investing for cash flow will allow you to capture more properties and therefore have more opportunity for appreciation. If you want to try to time appreciation or gamble on which areas will appreciate faster or higher… well, now you’re back to speculating as much as you are investing.

    I also believe you ignore the changing dynamics of home buyers. Remember McMansions? Don’t hear much about them do you? There was excess in homes built after 2,000 that will no longer be valued in a new market. The replacement cost may be $300,000 but if no one is building homes with those amenities any more, it may never get back to that price. I mean seriously, who’s going to build an all brick duplex rental now a days? My rentals will never approach their replacement cost because they were overbuilt by today’s standards. It’s going to take people a long time to forget this recession, be ready for new thought process in buying.

    • Nathan – Let me clarify – I was definitely not equating discounted market prices (compared to the peak) with a discount to replacement cost. In regards to calculating replacement cost, there are a number of good websites that will estimate the cost to build … but talk to a local builder and they can usually tell you what it costs them to build a house (it’s not rocket science).

      In regards to your assertion that “all homes are going to appreciate” … I can’t disagree with you more. Some markets will probably remain depressed for a long period of time and some will recover quickly. Also, understand that some markets fell a lot farther than others and have farther to bounce back. As an investor, I sure as heck want to know which markets have the best chance of recovering and when. The notion that “all markets are created equal so just buy for cash flow” is definitely not an idea I subscribe to … but more power to you.

      • Ken, thanks for replying… but now you seem to be mixing apples and oranges.

        The core of your argument seemed to be, and maybe I misunderstood, that you believe in appreciation because replacement cost is currently higher than market price. You seemed to imply, at some point those two need to become equal and eventually in a healthy market market value will be higher than replacement cost (i.e. builders will be able to sell for a profit).

        So based on that argument, I should simply be shopping for places that offer the largest discount to replacement cost as eventually the market value will need to rise to and surpass that number.

        Now, if the argument is that not all homes will eventually get back to replacement cost, then why do you believe in appreciation? You have just undermined your argument that you believe in appreciation because homes have to get back to replacement cost… but if they don’t need to, then there’s no guarantee of appreciation. If there’s no guarantee of appreciation, you’re back to speculating.

        Removing replacement cost from the argument… you’re back to trying to understand long term economic factors. Will Phoenix ever recover or is the cheap land or access (or lack thereof) to the Colorado River going to keep prices down? Will Vegas bounce back or is an economy solely based on one thing which rises and falls dramatically with the overall economy destined to die? How about Florida where high taxes, hurricane insurance, and Chinese drywall may scare away the baby boomers? Appreciation at an appreciable rate takes time… trying to predict things 10 – 15 years down the line… well, I’m not that smart… I call that speculation.

        • Ken Corsini

          Nathan – to clarify, you did misunderstand the core of my argument. My argument is not based on the fact that appreciation will happen solely because market values are less than replacement cost. My article was simply stating that there are a number of factors that point to a very real possibility for appreciation over the coming years. Yes, one of those factors is a comparison to replacement cost, but I would also include a comparison to previous market prices, inventory trends, growing demand, etc.

          So no, I do not believe an investor should simply shop in markets with the greatest discount to replacement cost. I was actually trying to make the point (I guess unsuccessfully) that it’s important to look at all of the dynamics at work in a particular market to determine whether there is a great opportunity for appreciation (which is why I discussed Atlanta – which is experiencing decreasing inventory and increasing demand).

          In regards to your assertion that trying to pick a particular market over another based on economic factors is “speculation” …. then so be it …. call me a speculator (I’d much rather own property in Atlanta than Detroit).

          In the end, the title of my article is “Why I believe …. “ , not “Why you should believe…” I realize that many investors invest purely for cash flow and I don’t fault them for that one bit – I think it makes a ton of sense. I just personally lean towards investing for upside right now …. and as fellow investors lets just agree to disagree on this.

  4. Steve Toohey on

    I wasn’t confused. Replacement cost is the cost to rebuild a similar structure. You can compute it, or accept the numbers your insurance company provides. I did not see where Ken implied a discount to peak prices was the same as a discount to replacement cost.

  5. Steve Toohey on

    Oh, by the way, I disagree 100% that you are “gambling” or “speculating” by selecting properties in areas you expect to appreciate faster or at a higher % than other areas. We all should have learned early on that LOCATION is the most important factor in real estate, and my investment strategy places location higher in the decision process than immediate cash flow ratios. I pick the more desirable areas with the good schools, and if I get a slightly lower % return I at least do not expect that area to degrade, I generally get better tenants, and appreciation will likely be higher. This is not speculation, it is making an informed business decision.

    • Steve – I agree with you – investing for location (and potential appreciation) makes all the sense in the world. The notion that researching a market and investing for upside is “speculative” or “gambling” is absurd ….especially if the market indicators point to this.

  6. Ken
    Good post, this is not an either or question.
    Many factors enter into what approach is best for any individual.
    Age is a big one.
    If one is 30 or 40, the scale tips towards appreciation.
    If one is 60 or 60, the scale tips towards towards cash flow.
    I have been a real broker in SF Peninsula since 19778.
    During the 80s and 90s, people we’re buying “investments” with BIG negative cash flows.
    These “investments” made NO sense unless appreciation was 7 to 10% a year (which happened for many many years).
    That being said, I do not believe it is prudent to buy investments with negative cash flow where your only savior is hopes for appreciation.
    In my opinion, any investment should at least pay for itself – break even or small positive cash flow at a minimum.
    I certainly understand that one investor might choose a small cash flow property with higher potential for appreciation over a higher cash flow property with less appreciation.
    As you note, it is up to each investor to weigh the scales of appreciation v cash flow.
    I am 57 so I am kind of right in the middle of the cash flow appreciation continuum.
    I do not need cash flow now cause my real estate brokerage business produces current income but 5 to 10 years from now cash flow will become more important.
    .
    Great time to invest right now.
    My advice is don’t try for the grand slam, just getting hitting line drives.

  7. This echos our strategy as well. We are targeting only the most highly regarded areas of town and subdivisions for our buy and hold SFH purchases. This sometimes means choosing a better area over higher cash flow elsewhere, but we choose to purchase properties that we would be happy to have our own family move into and could probably sell in almost any market if need be.

  8. Ken, I mainly buy REOs that have been remodel by wannabees. They go in do the costly stuff and walk away due to lack of money. I come in get it for 30-50 cents on the dollar and finish it. I end up with a lot of equity (60%+) and $300 plus cash flow per property. I don’t have to wait or depend on appreciation. The last five I bought were all large 4 bedrooms homes that took less than a week to finish, great cash flow and great equity. I’m greedy, I want both. Where ever one lives, there are good deals, just have to no where. Been buying/renovating for over 45 years, can’t believe the good deals and low interest rates one can get nowadays. Very good article.

    • David – thanks for the comments – I agree with you that investing should be approached with a balanced outlook of cashflow and equity. But I also believe now is a great time to capitalize on real estate that is undervalued and likely to increase in value.

      • Your right! but you should not bet on it. As long as you are cash flowing life is good. But hey if the house goes up great can a pull out equity to buy more real estate. As long as it cash flows.

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